The Netflix Niche

The rapid rise of Netflix isundeniably astounding. Thecompany added 3.1 millionsubscribers in the last three months of 2010to stand at just over 20 million at year-end,blowing past analyst forecasts. For the fullyear, it added 7.7 million net subscribers, up63% from 12.3 million at the end of 2009.

For many, Netflix represents the potentialend of the traditional cable-TV model bydelivering a cheaper, more user-friendly entertainmentpackage across more than 200different devices. Its streaming-only packagecurrently sells for $7.99 per month —less than two video-on-demand movies frommost major pay TV providers and as little ashalf what HBO costs per month.

“Netflix’s low-cost, subscription streamingservice (with improving content) is our biggestworry and could become ‘good enough’for consumers with moderate income and TVusage to use as a substitute for pay TV,” CreditSuisse analyst Spencer Wang and his teamwrote in a September 2010 report downgradingtheir rating on the U.S. media sector. ACredit Suisse survey found 17% of Netflix usersalready have cut the cord.

Netflix makes more than 20,000 titlesavailable for instant streaming and is continuallyramping up that library. Roughly half ofsubscribers’ online viewing is made up of TVshows and the other half are movies.

Despite all its growth and ambition,though, Netflix’s offerings are too narrowto shake the foundations of the cable, satelliteand telco TV business. Netflix, whichCEO Reed Hastings describes as a technologycompany, doesn’t offer live sports, newsor current primetime TV hits. And its businessmodel — an attractively priced alternativeto bricks-and-mortar video-rental stores— wouldn’t allow it to pay top dollar for thatcontent anyway.

“Netflix gives the appearance of having amuch deeper and broader library than yourservice provider, because the operators havedone a poor job of expressing what’s thereand making it available to consume acrossmultiple screens,” said Binder, who was thefounder of VOD startup Broadbus Technologies(now part of Motorola).

And in the case of TV shows, Netflix typicallyoffers only episodes of past seasons.“They don’t have the revenue to buy freshercontent,” said a media executive whose companylicenses some post-syndication showsto Netflix. “If they go that route, they’re goingto compete with DirecTV, Verizon andComcast.”

The telco, which had previously marketedthe service as U-verse On Demand,is touting that itoffers t it les upto 28 days beforeNetflix andthat customerscan watch manytitles on TV, aswell as online,on mobile devicesand with a MicrosoftXbox 360.

The company recently inked an expandeddeal with Disney-ABC TelevisionGroup, reportedly worth $200 million,which included shows from Disney Channeland ABC Family. Last summer Netflix,struck a deal with Epix, the joint movieventure of Paramount Pictures, Metro-Goldwyn-Mayer and Lionsgate, wortharound $1 billion over five years to providemovies 90 days after they premiereon linear TV.

“Our interest in television shows ishigh,” Hastings, together with newly appointedchief financial officer DavidWells, wrote in a letter to shareholderslast week.

As its subscriber base has swelled, Netflixhas become a target for critics complainingthat it is devaluing TV content.

‘200-POUND CHIMP’

Earlier this month, Turner Broadcasting Systemchairman and CEO Phil Kent warned studiosand other content producers that if theymake shows available through Netflix, Turnerwould probably pay less for them or even passon them altogether. Time Warner Inc. CEO JeffBewkes, in an interview with CNBC at the InternationalConsumer Electronics Show, dismissedNetflix as “a 200-pound chimp — it’snot an 800-pound gorilla.”

“Some consternation about Netflix successis natural,” Hastings and Wells said, comparingthe rise of Netflix to the arrival of the Foxbroadcast network 20 years ago.

“A new entrant bids up the price of content,and the incumbent aggregators are notpleased,” the executives wrote in their 2010shareholder letter. “Netflix is good for consumers,good for content producers, and isone more competitor for existing aggregators.”

But a backlash in the media business couldstarve Netflix and its ilk of high-value programming.“We aren’t saying that Netflix orother [over-the-top] providers will never getpremium subscription content again, but ourchannel checks indicate that willingness tolicense such content, especially for any reallength of time, is decreasing dramatically,”RBC Capital Markets analyst David Bankwrote in a Jan. 21 research note.

On the other hand, money talks, andNetflix has bragged about its willingnessto “write very large checks,” in the words ofchief content officer Ted Sarandos.

For example, Netflix expects to bid againstHBO for the rights to the pay-TV windowfrom Warner Bros. when that deal is up in2014. “We’re a nearly $100 million a year customerfor Warner Bros., and both of us wouldlike to expand that, if it makes sense to,”Hastings told analysts last week.

In the nearer term, Netflix is focused onrenewing with Starz Entertainment. Theirprevious agreement, struck in 2008 for a reported$30 million over three years, will expirein the middle of the first quarter of 2012.“[C]arrying Starz is one of our most importantdeals,” Hastings and Wells wrote last week.

Netflix has tried to point out that it augmentsthe content ecosystem, rather thancannibalizing it.

Since it began streaming Starz Play contentin October 2008, the number of Starzsubscribers through traditional pay TV distributors has grown, as HBO’s rolls have declinedover that time. “In other words, the evidenceis pretty clear that content that is alsolicensed to Netflix generates more money forits owners than content that is withheld fromNetflix,” Hastings and Wells said.

Netflix’s move to streaming is not onlyabout customer convenience. Just as significantly,the costs of Internet video deliveryare mere pennies versus approximately $1for each DVD mailed and returned.

Netflix last year paid more than $500 millionto the U.S. Postal Service to deliver DVDsby mail. “If we were paying a studio that much,we’d be their biggest customer,” Swasey said.

LAST-MILE ECONOMICS

Given Netflix’s shift toward Internet delivery,there’s a battle brewing with broadbandproviders over the costs of deliveringmassive quantities of content.

For cable operators or telcos to chargeNetflix or its content delivery networkpartners “to let in the bits their customershave requested from us… is inappropriate,”Hastings and Wells wrote last week.

That’s a reference to the standoff over network-interconnection fees between Comcastand Level 3 Communications, which landed acontract to be one of Netflix’s primary CDNs inNovember 2010. The MSO said Level 3 shouldpay in order to deliver more than double thetraffic to Comcast’s network, while Level 3 assertedthat any fees for delivering content toa broadband provider constitute a toll that isbarred under the Federal CommunicationsCommission’s network neutrality rules (see“Level 3 May Test ‘Open Net’ Rules,” Jan. 17).

However that spat plays out, to Binder,Netflix will always be unable to competewith facilities-based providers on efficientlydelivering high-quality content.

“The providers have the last-mile advantage— it’s the economics of moving contentover a public backbone versus over a privatenetwork,” he said. “The question is how longit takes [service providers] to effectively marginalizeNetflix.”

NETFLIX: BY THE NUMBERS

20 million: No. of subscribers as of Dec. 31, 2010, up 63% from 12.3 million a year earlier

$2.16 billion: Revenue for full-year 2010

$1 billion: Amount Netflix will pay Epix over five years for movie streaming rights

More than 200: No. of devices able to access Netflix instant streaming